Lecture 18 - ECONOMICS 100B Professor Steven Wood 03/17/11...

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ECONOMICS 100B Professor Steven Wood 03/17/11 Lecture 18 ASUC Lecture Notes Online is the only authorized note-taking service at UC Berkeley. Do not share, copy, or illegally distribute (electronically or otherwise) these notes. Our student-run program depends on your individual subscription for its continued existence. These notes are copyrighted by the University of California and are for your personal use only. D O N O T C O P Y Sharing or copying these notes is illegal and could end note taking for this course. LECTURE: Today’s lecture focuses on the Taylor Principle and Inflation Stability. TAYLOR PRINCIPLE: The Taylor Principle says that in order to stabilize inflation, the central bank will raise the nominal interest rate by more than any rise in expected inflation. This way, the real interest rate rises whenever there is a rise in inflation. Failure to follow the Taylor Principle means that nominal interest rates rise by less than the inflation increase, causing real interest rates to fall. This leads to an increase in equilibrium output, resulting in even higher inflation. FAILURE TO FOLLOW THE TAYLOR PRINCIPLE: If there is a temporary negative supply shock, the SRAS curve will shift up to SRAS 1 on the AS/AD diagram. At the new short-run equilibrium intersection of AD 0 and SRAS 1 , output increases to Y 1 and inflation increases to π 1 . If the central bank fails to follow the Taylor Principle on the MP curve, an increase in inflation to π 1 will result in a lower real interest rate r 1 . The MP curve will have a negative slope. On the IS curve, a lower real interest rate r 1 translates to higher output at Y 1 . On the AD diagram, higher output at Y 1 and higher inflation at π 1 results in an upward sloping AD curve. Now, because inflationary expectations have increased, the SRAS curve will shift up again from SRAS 1 to SRAS 2 . The new short-run equilibrium will be found at the intersection of SRAS 2 and AD 0 , with output at Y 2 and even higher inflation at π 2 . Overall, as long as the central bank fails to raise real interest rates in accordance with inflation, economic output will continue to increase, as will inflation. Failure to follow the Taylor Principle will lead to increasing economic output and accelerating inflation.
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ECONOMICS 100B ASUC Lecture Notes Online: Approved by the UC Board of Regents 03/17/11 D O N O T C O P Y Sharing or copying these notes is illegal and could end note taking for this course.
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This note was uploaded on 02/06/2012 for the course ECON 100A taught by Professor Woroch during the Fall '08 term at University of California, Berkeley.

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Lecture 18 - ECONOMICS 100B Professor Steven Wood 03/17/11...

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